The Sharpshooters

We Don’t Quit Know What We Are Talking About When We Talk About Volatility

Gregory — Wed, 15 Feb 2012 17:22:07 +0000

I have been skeptical for over three years now about the underlying assumptions and application of statistics for economic and financial metrics. In my last article I briefly touched on the former so I will now do so for the latter case. Again, I will address an acute
example as a primer.

Daniel Goldstein of the London Business School and Nassim Nicolas Taleb of NYU Polytechnic Institute published a paper in 2007 titled, “We Don’t Quite Know What We’re Talking About When We Talk About Volatility” and judging by their results it seems to be true. The question was to calculate a simple daily and annual standard deviation with given assumptions and data. Portfolio analysts, assistant managers, and managers, financial engineering students, and banking analysts for a major bank alike all got incorrect answers. Out of 87 selected participants only three got the first answer correct and zero got the second answer correct. However, I believe the crux of the study is not that the participants got the incorrect answer but the flawed logic that led them to it. The study noted that their knowledge of the formula was correct yet the participants seemed to reason that mean absolute deviation (MAD) and standard deviation (s) both second-order moments, are one and the same. MAD measures absolute differences in magnitude of error while s is a point estimate of the population standardized deviation. In other words, they are similar but different measures. Goldstein and Taleb also seem to point to a more in-depth analysis in that the sample standard deviation fails to account for outlying deviations that distort Gaussian tails. Namely, they pinpoint the ratio of these measures which is a type of fourth-order moment of kurtosis which is concerned with the curve height relative to the length it tail extensions which can have real effects on volatility measures. Its formulation is highlighted below in mathematical form as well in his paper (click expression):

If one reads Taleb’s book, Fooled by Randomness as well as seemingly any of his research this is a constant theme, stressing remote possibilities as having more influence in distorting the actual probability of outcomes despite their extremity. Thus, his particular case seems to include remote deviations via fourth-order moments as a more accurate measure of volatility. While these concerns may be more or less relevant depending upon on the data and hedging strategies in place, I suspect him to be on the fringe of academe in his notions to some degree and overall he certainly has articulated evidence to support his claims yet I do identify with most of his claims.

In the final analysis, I presented his work and my commentary as a challenge to a basic assumption in financial metrics as to conclude that with independent thought and unique analysis one can utilize more realistic and applicable knowledge and act on it profitably rather than reinforce inaccurate assumptions.

Bowerman, B., Koehler, A., O’Connell, R. (2005). Forecasting, Time Series Regression, and Regression (4th ed.). Belmont, CA: Thomson Brooks/Cole.
EnumaElish. (2007, November 22). Mean Absolute Deviation / Standard Deviation Ratio. Physics Forums. Retrieved February 11, 2012 from http://www.physicsforums.com/showthread.php?t=199764
Goldstein, D. G. & Taleb N. N. (2007). We Don’t Quite Know What We Are Talking About When We Talk About Volatility. Journal of Portfolio Mangement, 33 (4), 84-86. Retrieved Februaury 11, 2012 from http://ssrn.com/abstract=970480
SAS Institute Inc. (2006). Statistical Background. SAS Elementary Statisitcs Procedures. Retrieved February 11, 2012 from http://support.sas.com/onlinedoc/913/getDoc/en/proc.hlp/a002473332.htm

8 States May Legalize Marijuana This Year

Jonathan — Wed, 15 Feb 2012 12:10:40 +0000

The National Organization for the Reform of Marijuana Laws (NORML) released a list of states that have marijuana legalization propositions this year. I won’t get into general arguments for legalizing it – the economic benefits, the moral arguments, etc. – but I’ll focus on some of the specifics for these propositions.

I think these propositions will have more teeth than prior propositions, which aimed to legalize marijuana and regulate it. This raises the questions – regulate it like what? Alcohol? Cigarettes? Medication? Obviously these materials are regulated in very different ways and that would turn some people off to legalization. However, some of these propositions are good in that they specify the way they want to regulate it. For instance, there’s a proposition in California called “Regulate Marijuana Like Wine” which is pretty straight forward on how it’d be regulated. California has existing laws concerning how wine is regulated, it would simply be a matter of extending that to marijuana. This could make legalization more palatable as it gives people an idea how it would be treated.

There are marijuana advocates though who actually oppose legalization because it would be regulated. Now personally, I would not like to see regulation. I think that people can responsibly use marijuana as people can responsibly drink, and that they shouldn’t be limited by possession limits or taxes. Yet even in states where marijuana is decriminalized, marijuana possession can carry hefty fines and repeated offenses can carry jail time. Marijuana advocates should work towards legalizing marijuana to a point where users don’t have to fear being arrested for their activity and then work on getting rid of regulations.

Jobs And Fuel Prices Weigh On U.S Confidence

Gregory — Sat, 04 Feb 2012 06:24:20 +0000

I want to explain a specific point that serves to undermine the recent optimism in the final weeks of 2011, commodity inflation. It is my opinion that generally the scenario has been a combination of less dollars earned (i.e. unemployment) chasing a more expensive good (i.e. gasoline) which proportionally has diverted spending from non-essential consumption and savings which contributed to lower holiday retail sales, continuing weak housing activity, and lowered consumer confidence as reported in last Tuesday’s Financial Times article.

Going back to late 2009 the spot price of gasoline was trading around $1.20 and has since surged to $2.89. Problem is, since three years ago the inflation-adjusted amount of today’s spot of this price is $3.02, a differential of $.23. This price is according to the latest CPI data, an inflation rate of 4.8% which is a conservative estimate at best. Given that it has already been refined into gasoline, I suspect that crude oil fluctuations and refining expenses have been priced in. However, this price is at the wholesale level which is absent of distribution, retail profit margins, and taxes so these factors may explain most of the difference between spot and pump prices. However, my hypothesis is: if we had a bull market in line with such price appreciation we ought to expect similar price action prior to July of 2007 when demand was strong and crude oil was trading up to almost $150 per barrel. Conversely, since there has been a prolonged weak global economic environment since late 2008 and oil is currently trading below $100 one can reasonably conclude that perhaps there is some inflationary element fueled by the lack of demand and reflected in the divergence of crude oil and gasoline prices. Also, I suspect that a unitary change in gasoline spot price can be greater than it was during the lead up to the oil bull market of 2007. Thus far, my superficial analysis seems to indicate that this is the case on more than several occasions despite the seemingly strongly correlation between gasoline and crude oil in the graph below.

I only wanted to treat this specific subject as a starting point to make an accurate and informed first pass to the reader to think about such matters. There are a multitude of other economic factors that undermine such ignorance like monetary policy and quantitative easing, compliance with increasing regulations, and fiscal policy in lieu of U.S sovereignty credit downgrades. The point is that with some independent thought and more thorough analysis one can discover a more realistic and accurate economic state and act profitably despite the mainstream opinion.

Bond, Shannon (2012, January 31st). Jobs and fuel prices weigh on US confidence. Financial Times. Retrieved from http://www.ft.com
$GASO Unleaded Gasoline – Spot Price (EOD) (2012, January 31st). StockCharts.com. Retrieved January 31st 2012, from http://stockcharts.com/h-sc/ui?s=%24GASO
Inflation Calculator (2012, January 19th). US Inflation Calculator. Retrieved February 1st, from http://www.usinflationcalculator.com/
U.S Department of Energy (2012, February 1st). Weekly Cushing OK WTI Spot Price, Weekly New York Harbor Reformulated RBOB Regular Gasoline Future Contract 1. U.S Energy Information Administration. Retrieved February 3rd, from http://www.eia.gov/dnav/pet/pet_pri_spt_s1_w.htm

[Citation Needed] From SOPA, Protect IP Advocates

Gregory — Sat, 21 Jan 2012 05:51:30 +0000

S. 968, The Preventing Real Online Threats to Economic Creativity and Theft of Intellectual Property Act of 2011 (Protect IP) is being brought to the Senate by Patrick Leahy (D-Vermont) and 40 co-sponsors and is to be voted on the 23rd. Even though at this point it is most likely to fail, Senator Harry Reid (D-Nevada) is calling for a cloture vote later this month on their version of the Representative Lamar Smith’s (R-Texas ) Stop Online Piracy Act which comes to vote next month in the House.

Upon summary of this legislation it seems to seek to fulfill the shortcomings in intellectual property (IP) protection. As of 2009, a U.S International Trade Commission reported that they lost an estimated $48B from outside of its borders to China alone. Essentially, it is trying to securitize American business IP by empowering the Department of Justice’s Attorney General to use injunctions to cease and desist web sites outside of the U.S network by policing search engines, domain registers, advertisers, financial transfer payments, etc. It will grant immunity to comply with the law and who report such web sites. Problem is it expects online entities to police the Internet on behalf of U.S IP upon industry estimates that are unreliable according to Julian Sanchez. He also talks about how such firms maybe just circumventing competition and more precisely how much piracy is a result from not competing versus true pirating?

The thinking behind the opposition to this legislation seems to resemble a cum hoc ergo propter hoc argument. However, given the past histories of other legislation, I do have to give credence to this argument as being quite probable. Legislation proposed to stop international piracy may be passed and set precedence or be amended to thwart questionable domestic IP infringement as well further extorting content censorship and monopolization as protested by the likes of Wikipedia, Google, Facebook, etc.

Subsequently, it does raises some significant questions like, where does the right of IP ownership end? If I purchase the property, then do I not own it? Or have I purchased only the right to use it? At some point, transfer of ownership needs to take place when market profits have been taken in exchange for the property. In my opinion, what seems to be coming about is the use of lobbying in delimiting, controlling and maximizing profits of IP at the expense of competitive practices. By logic of the firms supporting this legislation it seems they wish to own the IP from production to personal ownership and it would require immense policing and regulation only starting with PROTECT IP and SOPA.

I think that the Federal government ought not to be involved in the protection of IP and profit interests of private enterprise to the extent that it has. Instead it ought to be private enterprise defeating or at least containing piracy by economic means via creating new modes of mediums and profitability, not protecting profits by lawsuits.

Sunlight Foundation. (2012). Congress (Version 1.0.0.0). [Mobile application software]. Retrieved from http://market.android.com/
United States International Trade Commision. (2011, May). China: Effects of Intellectual Property Infringement and Indigenous Innovation Policies on the U.S Economy. Retrieved from http://www.usitc.gov/publications/332/pub4226.pdf
Sanchez, Julian. (2012, January 18th). [citation needed] From SOPA, Protect IP Advocates. CATO Podcast. Podcast retrieved from http://www.cato.org/multimedia/daily-podcast/citation-needed-sopa-protect-ip-advocates
Israel, Josh (2012, January 18). Who Is Lobbying For And Against Protect IP Act. Retrieved from http://thinkprogress.org/politics/2012/01/18/406397/chart-who-is-lobbying-for-and-against-the-protect-ip-act/

IMF Requests $500B For Bail-Out Loans

Gregory — Wed, 18 Jan 2012 16:47:01 +0000

It comes to me as no surprise that the financial socialization in Europe has been working so well that the managing director of the International Monetary Fund (IMF), Christine Lagarde who is also the Finance Minister of France has requested an additional one-half trillion dollars. This in her own words according to the Financial Times is, “…ensuring adequate fund firepower to help defuse the current global economic weaknesses and regional challenges.” Evidently, almost two years of solutions is not enough or they were just poorly constructed solutions. Perhaps, this could this have something to do with the recent downgrade of the European Financial Stability Facility on Monday?

Europe seems to be only creating further layers of financial bureaucracy after its previous layer failed to achieve its purpose with no perspective on the issue. The European Union (EU), through the IMF is furthering not a closer fiscal union but a system of sovereign transfer payments and re-distribution of capital. It is akin to parents paying for their children’s credit spending instead of telling them to cut their liabilities and increase their revenue. I think it continues to be a more divisive manner within the EU rather than the intended effect. This is the result of privatizing gains (i.e. EU membership benefits) and socializing the risk (i.e. sovereign fiscal default) by those weaker member countries like Greece, Italy, Spain, and Portugal.

Beattie, Alan (2012, January 18th). IMF requests $500bn for bail-out loans. Financial Times. Retrieved from http://www.ft.com